w.9 Costs of Financial Distress

Question 1

Market firm value =

Answer 1

=value if all equity financed
+ PV tax shield
- PV costs of financial distress

Question 2

Costs of Financial Distress -

Answer 2

Costs arising from bankruptcy or distorted business decisions before bankruptcy (ie legal fees)

Question 3

costsof bankruptcy

Answer 3

Direct costs of financial distress are the legal and administrative costs of bankruptcy. Indirect costs include possible delays in liquidation (Eastern Airlines) or poor investment or operating decisions while bankruptcy is being resolved. Also the threat of bankruptcy can lead to costs.

Question 4

• Looking at additional expenses incurred from bankruptcy (legal fees, liquidation costs)
o Who pays for it?

Answer 4

The costs of financial distress – debt holders liable for bankruptcy cost

Question 5

“A company can incur costs of financial distress without ever going bankrupt.” Explain how this can happen.

Answer 5

• Bankruptcy can be postponed, but threat of financial distress also costs threatened firms, ppl don’t want to do business with them
• High debt and high financial risk reduces firm’s desire for having business risk

Question 6

Explain how conflicts of interest between bondholders and stockholders can lead to costs of financial distress.

Answer 6

1. Risk Shifting to bondholders

2. Refusing to contribute equity capital

Question 7

1. Risk Shifting to bondholders:

Answer 7

They want to invest in riskier projects that have higher returns, for their own return at the cost of the firm, even if it has a -ve NPV. In these instances, they will always get a higher return if the project succeeds compared to bondholders who will just receive fixed interest payments.

Question 8

2. Refusing to contribute equity capital

Answer 8

For safer projects which thus benefit bond holders and stockholders more similarly. If we hold business risk constant, any increase in firm value shared among bondholders & stockholders. The value of any investment opportunity to firm’s stockholders is lowered bc the project benefits must be shared w bondholders, so not always in stockholder’s interests to contribute fresh equity capital even if it means forgoing positive NPV projects
• This issue is a constant issue but most relevant for firms facing financial distress

Question 9

why do bondholders prefer safer projects when faced with financial distress threats?

Answer 9

• The greater the probability of default, the more bondholders have to gain from investments that increase firm value

Question 10

financial distress games

Answer 10

• Cash in and Run
• Playing for Time
• Bait and Switch

Question 11

cash in and run

Answer 11

• Cash in and Run – taking money out in in form of cash dividends etc. try to sell all asserts, convert into cash then dividends to pay themselves (extracting wealth from firm  debt holders lose, they receive the same amount)
• Now firm can only pay out dividends from current period
• The mv of firm’s stock decreases by less than the amount of the dividend paid bc the decline in firm value is shared w creditors

Question 12

Playing for Time

Answer 12

• Playing for Time - delaying the inevitable, ie legal cases, trying to extend bankruptcy/default, more time to cash in and run. They do this through accounting measures to conceal distress, encouraging false hopes of fast recovery, cutting maintenance corners, R&D etc

Question 13

Bait and Switch

Answer 13

• Bait and Switch – use dif. strategies to convince shareholders they’ll save the firm, when debt collapses debtholders payout more  pretty much banned now
• Start with conservative policy, issue limited amount of relatively safe debt and then you suddenly switch and issue heaps more. That makes all your debt super risky (high risk of default) imposing a capital loss on the ‘old’ bondholders, becoming the stockholder’s gain

Question 14

costs of games of financial distress

Answer 14

Basically these poor decisions about investments and operations are agency costs of borrowing, the more the firm borrows the more it wants to pay games, increased odds of bad future decisions reduces present market value of the firm.

Question 15

the costs of financial distress vary

Answer 15

with the type of asset.
Losses for bankruptcy usually greater for intangible assets that are linked to the health of the firm as a going concern (ie tech, human capital, brand image)

Question 16

pecking order theory

Answer 16

Pecking-order theory states that firms prefer to issue debt to rather than equity if internally generated funds are insufficient.
• 1. Internal financing
• 2. Debt
• 3. Equity (least preferred)
o Due to costs of issue of these, as it increases COC

Question 17

tradeoff theory

Answer 17

o Theory that capital structure is based on trade-off between tax savings and distress costs of debt
• A trade off btw the interest tax shields and the costs of financial distress, recognisinf that target debt ratios vary btw firms
• Companies with safe tangible assets and lots of taxable income to shield have higher target ratios
• Whilst riskier firms with intangible assets should rely primarily on equity financing
o Relates to industry effect that the firm is in.
o To an extent it is good at explaining industry differences in capital structure

Question 18

because capital structure irrelevance theory doesn’t adequately relate to real world, what theories have been created

Answer 18

tradeoff theory

pecking order theory

Question 19

limitations of tradeoff theory

Answer 19

why some successful companies thrive on little debt (ie Johnson & Johnson)
• Usually the most profitable companies borrow the least, but tradeoff theory says that high profits should mean greater debt servicing capacity, more taxable income to shield –> higher target debt ratio
• Trends show that companies won’t dramatically change capital structure for tax shield
• Also the imputation system of tax eliminates the value of the interest tax shields, the debt ratios have pretty much stayed the same (despite higher income taxes now than before)
• The theory isn’t beaten by this, just has weaknesses!

Question 20

Where does pecking order theory start from?

Answer 20

o Starts bc of asymmetric info (managers know more about company’s prospects, risks & value than outside investors.
- this info affects the choice btw internal & external financing btw issue of D or E. Therefore, there exists a pecking order for the financing of new projects.

• Asymmetric information favours debt issue over equity as the issue of debt signals the board’s confidence that an investment is profitable and that the current stock price is undervalued (were stock price over-valued, the issue of equity would be favoured).
• ——> The issue of equity would signal a lack of confidence in the board and that they feel the share price is over-valued. An E issue would therefore lead to a drop in share price. This does not however apply to high-tech industries where the issue of equity is preferable due to the high cost of debt issue as assets are intangible

Question 21

implications of the pecking order theory

Answer 21

1. Firms prefer internal finance
2. Adapt target dividend payout ratios to investment opportunities while avoiding changes in dividends
3. Internally generated cash flows is sometimes more than capital expenditures, other times not
   • Due to dividend policies, plus fluctuations in profitability and investment opportunities (also lots of projects available)
   • If more, firm pays off debt or invests in marketable securities
   • If less, firm first draws down cash balance or sells marketable securities
4. If external finances are required, firms issue the safest security first
   • They start with debt then possibly hybrid securities, such as convertible bonds, then equity as a last resort
   Dividend policy matters in real life  relates to capital structure due to taxation reasons (goes against MM theory)
   • Note that dividend policy is different in Australia due to imputation system of taxation.

Question 22

Tradoff vs Pecking /order theory

Answer 22

Tradeoff theory vs Pecking Order Theory
Research shows that debt ratios depend on:
1. Size. Large firms tend to have higher debt ratios.
2. Tangible assets. Firms with high ratios of fixed assets to total assets have higher debt ratios.
3. Profitability. More profitable firms have lower debt ratios.
4. Market to book. Growth firms (start up) with higher ratios of market-to-book value have lower debt ratios
Trade-off note that larger companies expected to borrow more and the market to book ratio indicates growth opportunities. Pecking order stresses the importance of profitability, arguing that firms use less debt bc they can rely on internal financing.

Question 23

overall summary of why firms prefer to have high liquidity (financial slack)

Answer 23

1. Ready access basically requires conservative financing so that potential lenders see the company’s debt as a safe investment.
   In the long run, a company’s value rests more on its capital investment and operating decisions than on financing.
   Therefore, you want to make sure your firm has sufficient financial slack so that financing is quickly available for good investments.

Question 24

Financial slack is most valuable to firms with

Answer 24

plenty of positive-NPV growth opportunities. That is another reason why growth companies usually aspire to conservative capital structures. Of course financial slack is only valuable if you’re willing to use it.

Question 25

Downside of financial slack

Answer 25

. Too much of it may encourage managers to take it easy, expand their perks, or empire-build with cash that should be paid back to stockholders. In other words, slack can make agency problems worse.

There’s a tendency of managers with ample free cash flow (or unnecessary ­ financial slack) to plow too much cash into mature businesses or ill-advised acquisitions. “The problem “is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it in organizational inefficiencies.”

then maybe debt is an answer. Scheduled interest and principal payments are contractual obligations of the firm. Debt forces the firm to pay out cash. Perhaps the best debt level would leave just enough cash in the bank, after debt service, to finance all positive-NPV projects, with not a penny left over.

Question 26

relative tax advantage of equity over debt

Answer 26

(1-Tp)/(1-TpE)(1-Tc)

p is personal tax on interest
pE is the effective personal tax on equity income

Question 27

if p = pE what is the relevative advantgae of D over Equtiy?

Answer 27

1/(1-Tc)